The recently filed bankruptcies of Jefferson County, Alabama and Harrisburg, Pennsylvania[1] provide only the latest examples of the difficulties many state and local governments have experienced in dealing with financial markets and complex financial instruments. While both these governments have multiple problems, in both cases considerable damage came from complex financings that went awry — Jefferson County for a sewer project, and Harrisburg for a municipal incinerator.

Local governments are confronting the need for large sums of short-term cash as expenditure pressures mount — from such needs as continuing public services and financing shortfalls in public pension systems — but the economic recovery remains slow. Many governments have engaged in or considered complex financial transactions to lower the cost of financing infrastructure such as sewers, roads and bridges. Others are considering equally complex transactions to sell or lease income-producing assets to private companies in exchange for current cash payments.

Not all of these transactions have proved to be in the best interests of those governments. Beyond Jefferson County and Harrisburg, numerous other governments have endured substantial financial losses from similar transactions when they failed to appreciate the considerable risks they were assuming. Local governments in Florida, for example, found themselves cut off from short-term funds after a state investment pool suspended withdrawals — driven by a loss of market liquidity. Numerous small towns in Tennessee and elsewhere have come under increased financial pressure due to their use of swaps and other derivatives, which many claim were not adequately explained by the investment banks who sold them. More recently, excessive fees charged by banks on complex interest-rate swaps have been estimated to cost state and local taxpayers as much as $20 billion.

Other local governments left long-term money on the table by agreeing to sales or lease terms that required them to turn over many years of future public revenues to private companies in order to get current cash. These amounts can be considerable. Analyses we have done of the leasing of the Chicago Skyway, for example, suggest that alternative financing structures would have produced as much as $1.6 billion in additional income for the city over a shorter period of time than the lease, without the need to transfer control of the asset to a private operator.

It is tempting to attribute these difficulties to fast-talking investment bankers pulling the wool over the eyes of unsophisticated state and local officials in desperate need of short-term cash. While this explanation is not entirely without merit, it is also true that many local governments failed to act appropriately. Governments have an obligation to taxpayers to manage the community’s assets responsibly, including getting appropriate prices for income-producing assets and not taking on risk beyond their capacity to manage it properly. The short-term financial pressures that led state and local governments to find complex financial instruments attractive are likely to persist or become more intense going forward, and governments should be able to avail themselves of the potential benefits of these instruments. Doing so in an effective and responsible manner, however, requires bankers, governments and financial advisors to governments to pay attention to three matters.

One is the proper management of risk. Many complex financial instruments are based on relationships between different sets of interest rates. These rates are volatile, however, creating the risk that the relationships between these rates will change in unfavorable ways and once-profitable deals will go bad. In the simplest case, for example, governments may save considerable money via variable-rate financing when short-term rates are low relative to fixed rates, but are at risk if interest rates go up and debt-service costs increase substantially. This risk needs to be understood, measured and monitored in order to take appropriate remedial action. Many of these instruments are not traded on financial markets, making a “fair” price difficult to determine. Neither bankers nor local governments appear in many cases to have understood or communicated these risks effectively in particular transactions nor to have established methods for monitoring and managing risk. Closer attention to these matters on both sides seems to be in order.

A second matter that deserves greater consideration is attention to the long run. Public officials are of necessity focused on current budget problems and can be expected to find attractive those proposals that fix their short-run budget troubles. This short-term orientation can cause them, however, to neglect what’s in their government’s long-term interest. Governments with short-term budget problems may well be willing to sell or lease income-producing public assets at “fire sale” prices that are financially damaging in the long run. Perhaps more important, the short-term problem may make it difficult for officials to consider alternatives that allow them to maintain control over valuable public assets. The mayor of Harrisburg has, for example, raised the possibility of paying down the city’s substantial debt by selling or leasing other city assets. Given the city’s dire financial straits, it is difficult to imagine that Harrisburg would be able to secure anything like a fair value for these assets.

Finally, governments and financial advisors to governments have mutual obligations to effectively manage complex financial matters. Rather than simply providing information on the mechanics of arranging transactions, financial advisors need to actually advise governments on the degree of risk involved and provide the means to monitor and manage that risk. Such ongoing advice is expensive, but governments wishing to engage in complex financial transactions should be prepared both to pay for it and to heed it, even when it conflicts with desires for short-term budget fixes.

Achieving these improvements will likely be a long and complex process. Currently, the primary sources of information on these financial instruments are the investment banks that design and market them. There is little independent scholarly research that evaluates them. Few finance staff members in either executive or legislative branches have the necessary skills to make sense of these instruments or to evaluate changing risk conditions on an ongoing basis. Most governments are unable to compete for the limited number of graduates of “financial engineering” programs with the skills necessary to properly vet these instruments. Many of the professional associations that provide technical assistance and advice to governments lack the requisite expertise to do so. Currently, only a few financial services firms offer to vet at least some types of transactions for local governments.

Yet the need is great to make these transactions more transparent and improve governments’ ability to manage risk and properly use complex financial instruments. How can governments achieve those goals? A good first step might be to increase the supply of independent information and advice available to local governments through expanded scholarship and assistance from professional associations and financial advisors.